The Anatomy of Sovereign Default

The three primary factors that determine the interest rate level a nation
must pay to service its debt in the long term are; the currency, inflation
and credit risks of holding the sovereign debt. All three of those factors
are very closely interrelated. Even though the central bank can exercise tremendous
influence in the short run, the free market ultimately decides whether or not
the nation has the ability to adequately finance its obligations and how high
interest rates will go. An extremely high debt to GDP ratio, which elevates
the country's credit risk, inevitably leads to massive money printing by the
central bank. That directly causes the nation's currency to fall while it also
increases the rate of inflation.

It is true that a country never has to pay back all of its outstanding debt.
However, it is imperative that investors in the nation's sovereign debt always
maintain the confidence that it has the ability to do so. History has proven
that once the debt to GDP ratio reaches circa 100%, economic growth seizes
to a halt. The problem being that the debt continues to accumulate without
a commensurate increase in the tax base. Once the tax base can no longer adequately
support the debt, interest rates rise sharply.

Europe's southern periphery, along with Ireland, has hit the interest rate
wall. International investors have abandoned their faith in those bond markets
and the countries have now been placed on the life support of the European
Central Bank. Without continuous intervention of the ECB into the bond market
yields will inexorably rise.

The U.S. faces a similar fate in the very near future. Our debt is a staggering
700% of income. And our annual deficit is over 50% of Federal revenue. Just
imagine if your annual salary was 100k and you owed the bank a whopping 700k.
Then go tell your banker that you are adding 50k each year--half of your entire
salary--to your accumulated level of debt. After your bankers picked themselves
off the floor, they would summarily cut up your credit cards and remove any
and all existing lines of future credit. Our gross debt is $15.6 trillion and
that is supported by just $2.3 trillion of revenue. And we are adding well
over a trillion dollars each year to the gross debt. Our international creditors
will soon have no choice but to cut up our credit cards and send interest rates
skyrocketing higher.

When bond yields began to soar towards dangerous levels in Europe back in
late 2011 and early 2012, the ECB made available over a trillion Euros in low-interest
loans to bailout insolvent banks and countries. Banks used the money to plug
capital holes in their balance sheets and to buy newly issued debt of the EU
nations. That caused Ten-year yields in Spain and Italy to quickly retreat
back under 5% from their previous level of around 7% just a few months prior.
But now that there isn't any new money being printed on the part of the ECB
and yields are quickly headed back towards 6% in both countries. There just
isn't enough private sector interest in buying insolvent European debt at the
current low level of interest offered.

The sad truth is that Europe, Japan and the U.S. have such an onerous amount
of debt outstanding that the hope of continued solvency rests completely on
the perpetual condition of interest rates that are kept ridiculously low. It
isn't so much a mystery as to why the Fed, ECB and BOJ are working overtime
to keep interest rates from rising. If rates were allowed to rise to a level
that could bring in the support of the free market, the vastly increased borrowing
costs would cause the economy to falter and deficits to skyrocket. This would
eventually lead to an explicit default on the debt.

But the key point here is that continuous and massive money printing by any
central bank eventually causes hyperinflation, which mandates yields to rise
much higher anyway. It is at that point where the country enters into an inflationary
death spiral. The more money they print, the higher rates go to compensate
for the runaway inflation. The higher rates go the worse economic growth and
the debt to GDP ratio becomes. That puts further pressure on rates to rise
and the central bank to then increase the amount of debt monetization...and
so the deadly cycle repeats and intensifies.

The bottom line is that Europe, Japan and the U.S. will eventually undergo
a massive debt restructuring the likes of which history has never before witnessed.
Such a default will either take the form of outright principal reduction or
the central bank to set a course for intractable inflation. History illustrates
that the inflation route is always tried first.

PPS is a Registered Investment Advisory Firm that provides money management
services and research for individual and institutional clients.

Michael is a well-established specialist in markets and economics and a regular
guest on CNBC, CNN, Bloomberg, FOX Business News and other international media
outlets. His market analysis can also be read in most major financial publications,
including the Wall Street Journal. He also acts as a Financial Columnist for
Forbes, Contributor to thestreet.com and is a blogger at the Huffington Post.

Prior to starting PPS, Michael served as a senior economist and vice president
of the managed products division of Euro Pacific Capital. There, he also led
an external sales division that marketed their managed products to outside
broker-dealers and registered investment advisors.

Additionally, Michael has worked at an investment advisory firm where he helped
create ETFs and UITs that were sold throughout Wall Street. Earlier in his
career he spent two years on the floor of the New York Stock Exchange. He has
carried series 7, 63, 65, 55 and Life and Health Insurance Licenses. Michael
Pento graduated from Rowan University in 1991.